No Longer Soaring

Exchange-traded funds started the year strongly, but many retreated in April and May, as concerns mounted about the sputtering U.S. recovery, the future of the euro zone and the slowing pace of growth in China

The largest ETF, the SPDR S&P 500, had a total return of 0.71% for year to date as of May 30, not negative, but hardly a robust showing.

The best-performing ETFs in the market included some sectors that might hold up even amid economic weakness. Health-care ETFs were up 9.4%, perhaps helped by the idea that people spend money on their health regardless of economic swings; the global real estate category bumped up 9.3%; and high-yielding municipal debt ETFs increased 9.2%, as investors apparently felt more comfortable with the fiscal health of state and city governments.

ETFs that focus on commodities performed poorly through the first five months. Precious metals were down 18.4%, owing in part to a shaky outlook for gold miners. Energy ETFs were down 12.3%, and global natural resources ETFs were off by about 11.3%.

These declines may be pegged to an expected deceleration in the pace of development in China. "I think people worry about a slowdown in the Chinese economy," says Jeff Tjornehoj, a senior research analyst at Lipper. "Fear of a slowdown there has sent earthquake tremors through the commodities market."

This sentiment was also reflected in net asset flows, according to the observers. The iShares FTSE China 25 (FXI), for instance, is attractive to many investors because it is one of the largest pure plays on China in the ETF market, Tjornehoj says. But through May 30, investors pulled out 2.4% of that ETF's total assets, leaving it with about $5.2 billion.

"It suggests people are getting caught up in the moment, as far as news coming out of China," he says. "It could be either brilliant foresight, or investors adding too much volatility and trading to their accounts. We'll find out."

Fixed-income ETFs did particularly well in terms of net fund flows. The group, which encompasses corporate, high-yield and government bonds, took in $28 billion through May 30, says David Mazza, a strategist in State Street Global Markets' SPDR ETF strategy consulting group.

EMBRACING DIVIDENDS

But that does not mean investors backed off of equities entirely. Dividend fundamental ETFs, for instance, took in nearly $8.9 billion. "Within the equity space, there are still investors who are willing to commit," Mazza says. "They are tending to seek out those ETFs with defensive characteristics. In a low-yield environment, that is something they are not getting in the fixed-income space, such as sovereign bonds."

Concerns about sovereign bonds could help to set the tone for the second half of 2012. Specifically, Tjornehoj predicts that investors will be more cautious and engage in defensive trading. He thinks investors are generally uneasy with both undeveloped and developed markets.

Mazza added that investors would pay continued attention to macroeconomic issues and political situations, culminating in the U.S. presidential election. This is not necessarily bad for ETFs. "The ETF industry is poised to do well from some uncertainty, because of the options ETFs offer investors, and the broad-based transparency they offer," Mazza said.